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Individual Businesses can cause Bankruptcy?

  • blog
  • 24th Feb, 2021
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Individual businesses on the verge of bankruptcy due to the liquidity crisis in the banking sector. Here is our thoughts.

After the hit from the Novel Coronavirus/ Covid-19 businesses were on the verge of shutting down. However, after the lockdown was lifted and international flights started, everything started getting back to normal. It was when the business people started seeing the chance to grow their business and make up for the losses they had to bear because of the pandemic. Besides the big players in the business and the finance, almost everyone was affected so everyone needed to do something for which they needed a loan.

Since everyone started looking for a loan in the bank to make up for their losses, now the banks are running out of cash to lend the customers loan because the loan demand is skyrocketing and banks do not have enough cash or easily convertible cash to provide to the borrowers. This is what the liquidity crisis in the banking sector is all about. Because of the liquidity crisis, lack of cash on hand for individual institutions will lead to an acute increase in demand for the loan and that will create a decrement in the supply of liquidity, which in turn is likely to lead to widespread defaults and bankruptcies at the worst situation.

About liquidity crisis and bank runs a model was given by Diamond and Dybvig in 1983 which demonstrated how it all works and the process of a bank being vulnerable to a bank run. During the liquidity crisis, the prices of the assets drop significantly low therefore the assets prices are subject to liquidity risk. And the higher the asset’s market liquidity risk, the higher will be its required return according to the liquidity-adjusted CAPM pricing model.

We can take the example of the company Long-Term Capital Management. It was a huge hedge fund that had about 126 billion US dollars in assets. It was successful at the beginning which gave above 21% annual return in the first year followed by 43% and 41% in the second and the third year simultaneously. However, because of the 1997 Asian financial crisis and the 1998 Russian financial crisis, it got hit by a huge blow. It made them lose about 5 billion US dollars in less than four months in the year 1998. On September 23 of the same year 1998 the company collapsed with the agreement among the 14 financial institutions which included; Bankers Trust, Barclays, Chase Manhattan Bank, CréditAgricole, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, JP Morgan, Merrill Lynch, Morgan Stanley, Paribas, Salomon Smith Barney, SociétéGénérale, and UBS. Under the supervision of the Federal Reserve, recapitalization was done and the find was liquidated and dissolved in the early 2000s.

The lesson that Long-Term Capital Management taught other companies is that no matter how big amount of assets you have when there is a liquidity crisis in the market the value of liquid assets goes down significantly low. The liquidity crisis also relates to the growth of the market. In an emerging market, there is always a higher chance of liquidity crisis because due to financial liberalization and an increase in inflows of foreign capital in short term can worsen the liquidity of banks and increase their vulnerability. When the market is emerging everyone is looking for more loans from the bank. Moving from small scale industry workers to large scale industries, everyone wants more capital to invest in their business to make more.

Because of the excessive lending rate exceeding the deposit rate, lending to the unproductive sector and the inability to spend the allocated capital budget, there is a liquidity crisis in a bank or any other organization. All these factors lead to the effect of an increase in the interest rate and restraints on loan policies making the loan taking process more difficult and costly. At such times when a bank or a company is on the verge of Bank Runs the investors fear that the bank is going to go bankrupt or they think that the bank will run out of enough assets to pay all the depositors which create more problems for the bank/company.

There is always a fear that they might not get the amount of money they deposited before when there is a financial crisis. One thing that you can do to minimize the risk of losing your money because the company or bank that you invested in is likely to go on a bank run is diversifying your investments. Instead of investing in a single firm or a company if one divides a big amount and invests in different places the risks are comparatively less.

On the side of banks, the thing that creates a liquidity crisis is the inability of the borrowers to return the loan they took from the bank. To make sure that banks get the money they lend borrowers, a good inspective department needs to be set up which monitors the situation of the individual or the business, see prospects of them to make a profit from the money they took and be able to return it to the bank.